Friday, 13 June 2014

Reciprocity and the difference between usury and interest

At the IASH meeting on the Human-Business interface I attended last week, Michael Northcott discussed the relationship between capitalism and sustainability. Michael is an authority on both subjects, having written on environmental ethics and debt. At the end of Michael's presentation I made the point that theologians distinguished interest ad usury in the past, a distinction that was missing in Michael's discussion.

Usury derives from the Latin usus, meaning 'use', and referred to the charging of a fee for the use of money. Interest comes from the Latin interesse, meaning 'compensation for loss', and originated, in the Roman legal codes as the fee someone was paid if they suffered a loss as a result of a contract being broken. So a lender could charge interest to compensate for a loss, but they could not make a gain by lending.

It is easier to understand this distinction with a simple example. A farmer lends a cow to their cousin for a year. In the normal course of events, the cow would give birth to a calf and the cousin would gain the benefit of the cow's milk. At the end of the loan, the farmer could expect the cow and the calf to be returned. The interest rate is 100%, but it is an interest since the farmer, if they had not lent the cow to their cousin, would have expected to end the year with a cow and a calf. Similarly, if the farmer lent out grain, they could expect to get the loan plus a premium on the basis that their cousin planted the grain, he would reap a harvest far greater than the sum lent.

Because money is 'barren', unlike land or labour it could not 'produce' anything. As a result, money can have no intrinsic value, other than its use to facilitate exchange, and so charging for the lending of money is essentially selling something that has no value. Thomas Aquinas argued that

To take usury for money lent is unjust in itself, because this is to sell what does not exist, and this evidently leads to inequality which is contrary to justice.

So, usury contradicts 'natural law'. Even if you could convince the canon lawyers that you were, in fact, selling something that did exist, the theologians might argue that usury was an affront to God because, since money was barren, the usurer was charging for time, and "time was God's exclusive property''.

In theory, this is all very clear, in practice there was still the question of where the dividing line between usury and interest was and almost everyone who was handling money was looking to charge as much interest as was permissible.

Around 1236, an English professor of canon (church) law, Alanus Anglicus, argued that usury did not exist if the future price of the good was uncertain in the mind of the merchant. These theories became established in the medieval legal system between 1246 and 1253 by Pope Innocent IV, a former professor of law at Bologna. Not only could a merchant adjust the 'just price' to cover their labour and expenses, but also they could also adjust the price to take into account the risk they bore, called an aleatory contract, from the Latin word alea for chance. In establishing this principle, a Catholic jurist initiated the scientific study of financial risk.

Today, financial economics models interest through a force of interest, r, and so the value of a loan of X0
at time t = 0 would be repaid by an amount XT given by

This implies that the
repayment amount Xt is the solution to the
most basic differential equation,

that is, Xt grows at a
constant rate r. This links to Piketty’s thesis that
capitalism induces inequality because r, the return on money,
is greater than g the growth rate of the economy. This is
conventional economic theory.

In 1837 Poisson wrote Recherches sur la
probabilité des jugements en matiére criminelle et enmatiére
civile (‘Research on the Probability of Judgments in Criminal
and Civil Matters’). Despite its title, most of Possion’s book
was a development of ‘probability calculus’, and according to the
historian of probability, Ivo Schneider, after its publication “there
was hardly anything left that could justify a young mathematician
from taking up probability theory”.
The heart of Recherches was a single chapter
on determining the probability of someone being convicted in a court,
by a majority of twelve jurors, each of whom is “is subject to a
given probability of not being wrong” and taking into account the
police’s assessment of the accused’s guilt. In order to answer
this problem, Poisson needed to understand what has become known as
the ‘Law of Rare Events’, in contrast to the Law of Large
Numbers. Poisson’s starting point was the Binomial Model, based on
two possible outcomes such as the toss of a coin, or the
establishment of innocence or guilt. De Moivre had considered what
would happen as the number of steps in the ‘random walk’ of the
Binomial Model became very large, with the probability of a success
being about half. Poisson considered what would happen if, as the
number of steps increased, the chance of a success decreased
simultaneously, so that it became very small.

On this basis, Poisson
worked out that if the rate of a rare events occurring, the number of
wins per round, was r, then the chance of there being k
wins in n rounds was given by

the Poisson distribution. Apart from being one of
the key models in probability, along with the Binomial and the
Normal, the Poisson distribution has an important financial
interpretation.

Consider a banker
lending a sum of money, X0. The banker is concerned
that the borrower does not default, which is hopefully a rare event,
and will eventually pay back the loan. Say the banker assesses that
the borrower will default at a rate of r defaults a day, and
the loan will last T days. The banker might also assume that
they will get all their money back, providing the borrower makes no
defaults in the T days, and nothing if the borrower makes one
or more defaults. On this basis the bankers mathematical expectation
of the value of the loan is

we can ignore the second expression,
since it is zero, and for the first, using the Law of Rare Events, the probability of no defaults is given when k = 0 we have that (rT)0
= 1 and 0! = 1, so
E[loan] = X0e-rT.

So the banker is handing over X0
with the expectation of only getting X0e-rT< X 0 back. To make the initial loan
amount equal the expected repayment, the banker needs to inflate the
expected repayment by erT,

That is, the repayment amount needs to be

.

We can interpret interest in two ways, as a means of "growing" ones wealth, which would be usurious in the Scholastic sense, or as a compensation. If it is a compensation the wealth is not expected to grow, that is, Piketty's whole argument becomes somewhat meaningless.

Michael Northcott argued that the Christian prohibition on usury/interest was related to an intent to inhibit human bondage and he noted that contemporary Islamic finance still prohibited the charging of interest. There in lies a counter argument to the interest equates to slavery claim, it was capitalist Britain that led the way in the emancipation of slavery, Islamic jurisdictions retained slavery into the second half of the twentieth century.

I agree with Michael that usury is a form of bondage, but I do not agree that the charging of interest is usurious, particularly if the interest is determined on the principle of balanced reciprocity. The problem contemporary finance faces is that it emphasising economic growth over social cohesion, the distinction between usury and interest is obscured.

Posted by
Tim Johnson

9 comments:

I think the essence of a ban on usury was the “insight” that in a pre-modern economy with fixed resources and no technical change, the optimal interest rate was r=g=zero. Any departure from zero would imply unjust monopoly power in some market.

In college philosophy class I came across this argument: Theft is not possible because ownership is not possible, therefore, one should not steal.

But if theft wasn't possible we would hardly need to make arguments against it! Similarly, to say that money has no intrinsic value, therefore we shouldn't charge interest for its use is to deny experience. If money has no intrinsic value then WHY do you want to borrow it?!

I think we need to accept that there is a difference between interest and usury, but not a clearly defined difference.

Given that contracts are mostly made on nominal terms and that taxes are levied on commercial transactions, is it not possible that the borrower can default on the loan simply because the money interest has not been created into existence (an accounting fact that loans create the principal but not the interest)? Wouldn't the default event be certain?

That my friend has been my point for eons. That's where Booms and Busts come in. The Boom widens or expands the AMOUNT of currency in circulation, digitally or physically, the Bust returns the cash to the system for redistribution as interest on Savings, Investments and of course the Bankers get their share for running this scam. But a lump of gold weighing a pound is the same lump of gold weighing a pound no matter how much interest was promised to accrue.

Or more simply a 20% guaranteed fail rate seems built into our current system so as to perpetuate its existence. If 20% of the people are not in or at failure at all times then the system could not work.

Isn't usury the same thing as rent seeking? And don't economists agree with the Christians (though on different grounds) that this would be wrong? And isn't there a lot to say for the fact that rent seeking in the present day increases (e.g. CEO salaries)? And isn't this what Piketty is talking about? So I disagree with your opinion "that the charging of interest is usurious, particularly if the interest is determined on the principle of balanced reciprocity", at least in our present real world.

The Jewish law of usury -- well-developed over the course of 1800 years of jurisprudence -- explicates these concepts extensively. For example, interest was permitted is the future market price was unknown, but not if it was.

If I use borrowed money to buy a cow, to use your example, in a year I have two cows and a lot of cheese. I sell one, repay the loan, and still have a cow and much cheese. Money has no value? What am I missing? Don't I at least owe the lender a bite of brie?

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About Me

I am a Lecturer in Financial Mathematics at Heriot-Watt University in Edinburgh. Heriot-Watt was the first UK university to offer degrees in Actuarial Science and Financial Mathematics and is a leading UK research centre in the fields.

Between 2006-2011 I was the UK Research Council's Academic Fellow in Financial Mathematics and was involved in informing policy makers of mathematical aspects of the Credit Crisis.